So What is 'Forex'?
The word 'Forex' is simply a shortening of 'Foreign Exchange'. Forex trading is when traders buy and sell different currencies from one currency to another.
So, for example, if you were to buy the European currency (the Euro, EUR) with US Dollars (symbol USD), then you would be 'buying the Euro' and at the same time 'selling the US Dollar'. You would effectively be betting that the value of the Euro compared to the Dollar would increase to have any chance of receiving a profit. Another way of thinking about this trade is that you are going 'Long' on the EUR/USD.
Many people find this concept a little tricky to understand. Why would this particular trade be selling the Dollar? Well, if the Dollar were to drop in value compared to the Euro (remember that you have bought your Euros with US Dollars), then you would be able to buy back more Dollars than you started with, using the Euros which have become more valuable in relative terms. In other words, you would have profited from the decline of the Dollar.
Base and Quote Currencies
The first currency quoted in a currency pair is called the base currency and the second currency is called the quote currency. In the above example, the base currency is the Euro and the quote currency is the US Dollar.
So you may see a quote like this:
EUR/USD = 1.2288
This means that 1 Euro (the base currency) is presently worth 1.2288 US Dollars (the quote currency).
Forex traders usually place a trade through a broker who have direct access to the fx market via an associated partner in the Interbank Market. When you close out your trade, your broker will close the position with this partner and calculate the loss or gain on the trade, which is then applied to your brokerage account. These days, high speed communications and technologies which link all players in the FX market mean that trades can be opened and closed in a matter of seconds.
Forex Trade Example
Here's an example of a currency trade. Suppose you thought that the Euro was going to weaken compared to the US dollar in the coming weeks (note that forex traders can trade on timescales ranging from minutes to years). This time, going short on the EUR/USD assuming this belief turns out to be correct would be a smart move.
There are no 'shorting' restrictions in the forex market (unlike the stock market) so this trade would be very straight forward to place through your broker as long as you had the required deposit.
So the quote today might be:
EUR/USD = 1.2288
You think the Euro will decline in value against the USD, so you place a short order on this currency pair and purchase 1000 Euros. This costs you $1228.80 US Dollars.
The next week, the quote is now:
EUR/USD = 1.2008
1 Euro is now only worth $1.2008 US Dollars. Having shorted this currency pair (which is the same as going long on the USD/EUR opposite currency pair), you will have made a profit of $0.0280 x 1000 = $28.
Note, it is important to realize that your broker will take a brokerage fee from both placing the trade and closing out the trade, whether or not you make a profit.
Forex currency pairs are usually traded on futures markets such as the Chicago Mercantile Exchange (CME).
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